Tax impacts of renting your cottage, selling U.S. property

Thinking about putting that cottage up for sale? Plenty of people are thinking of cashing in, given the high demand – and commensurately higher prices – for out-of-town properties during the pandemic. But that sale could come with a host of unwanted side effects. No, not mosquitoes, but taxes. Last time I outlined the tax effects of a cottage sale and the ins and outs of transferring a property to a family member. This time, we'll look at the implications of renting out your piece of paradise, and what to do with a property south of the border.

Renting out your second home

If your cottage is not your principal residence, the proceeds of any sale could be subject to capital gains tax. If so, you may want to consider a scenario where your second home doubles as a rental property. And from my desperate searches on VRBO and AirBNB, renting your cottage over the summer can also net you quite a windfall these days. 

Moreover, even though such rental income is taxable, you are entitled to claim applicable expenses (including any mortgage payments). Often, these expenses can really mount up and may put you into an overall loss position (although maybe not this summer, given the premium rents cottages are commanding). But, any losses are potentially available to shelter other sources of income, be it from your job or other sources. (Note, though, that if the second home is a farm, there are usually restrictions on the amount of annual losses that can be claimed, known as "restricted farm losses.")

But for those who are tempted to pile up the write-offs on rentals, a word of warning: The Canada Revenue Agency (CRA) has been known to carefully monitor taxpayers who consistently claim rental losses over a period of several years, and may well attack your claim based on the premise that there must be a reasonable expectation of profit. Although this line of attack was generally shot down by the Supreme Court of Canada in two landmark cases (Stewart and Walls), the cases drew an exception for properties that involve an element of personal use. So CRA can – and will – still attack.

Selling property south of the border

Other complications may arise if the second home is located outside of Canada, particularly in the U.S.

Withholding tax. If you sell U.S. real estate, there is a U.S. withholding tax. The tax withheld may be offset against U.S. tax payable on the capital gain. Happily, there is no withholding if the sale price is less than US$300,000 and the purchaser intends to use the property as a principal residence. However, the gain on the sale will still be taxable in the U.S., and you will have to file a U.S. tax return. (It is also possible to go through certain procedures to reduce the withholding.)

Your papers, please. On a sale of your real estate, you will need to provide an Individual Taxpayer Identity Number (ITIN) to the transfer agent. This will be so, even if there is no withholding tax due. The sale cannot close without both the vendor and purchaser providing an ITIN. In addition the Internal Revenue Service (IRS) will not issue a receipt for the withholding tax paid unless both the vendor and purchaser provide an ITIN. An ITIN can be obtained by filing Form W-7 with the IRS. Warning: This is at least a six-week process.

U.S. tax filing. If you sell your U.S. home, you will have to file a U.S. tax return to report the gain (a credit may be claimed for tax withheld under the U.S. Foreign Investment Property Tax Act (FIRPTA). This filing is required even where there is no withholding tax due. 

The current capital gains rate in the U.S. for individuals is currently 15% if held for a long time, and the gain is under $445,800; for those with gains above that, the capital gains rate is 20%; however, the Biden Administration has proposed an increase of this rate to just over 39% for those who have income over $1,000,000 (which is well over the Canadian tax rate of 26.7%). So, depending on the amount of the gain on your U.S. property, your U.S. tax bill can be higher than your Canadian tax bill.

If you have owned the U.S. property since before Sept. 27, 1980, you can take advantage of the Canada-U.S. Tax Treaty to reduce the gain. In this case, you will have to pay tax only on the gain that accrued since Jan. 1, 1985 (this does not apply to business properties that are part of a permanent establishment in the U.S.). To claim this treaty benefit, you have to make the claim on your U.S. tax return and include specific information about the sale.

Foreign tax credit. Any U.S. tax paid on the sale of the property will generate a foreign tax credit, which you can then use to reduce your Canadian tax on the sale. Note: This tax credit may be limited if you use your principal residence exemption to reduce your Canadian gain.

Previously published in The Fund Library on July 13, 2021

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.